Is UCITS III another damp European squib that will sputter weakly before crashing? Certainly a head of steam seems to be building up among the professionals very much involved in implementing its provisions, both from the aspects of what is not in it as much as for what is in it.
The directive is aimed ultimately at improving choice and ease of accessing investment funds for investors in the EU. Whether that happens depends very much on the promoters of funds and the support industry that enables them to take their funds across border. Their reactions to the opportunities are going to determine the extent to which a common market in funds develops through more UCITS-conforming funds with their enhanced investor protection for a wider variety of funds.
The outlook may not be too hopeful, judging by the reactions of service provider groups, such as JP Morgan Investor Services.
The Ucits provision is made up of two directives. The Product Directive allows the creation of new types of funds, such as funds of funds, but not hedge funds or real estate funds, extends the range of securities and allows greater use of derivatives beyond portfolio efficencies and hedging as previously permitted. The Management or Profession Directive enables management companies to passport their activities across the EU.
Chris Edge, a senior vice president at JPMIIS, speaking in London recently said the focus of the directive from an investor view was focused entirely on increased investor protection and “not at all on benefiting the investor by creating scope to remove cost from the service chain”. For example, a major disappointment is the inability for administration companies to passport their services across Europe. These had been included in the first draft of the directive but did not survive. “The scale benefits from centralising could be enormous,” he said. Presumably, the prospect of this administration being located in Dublin or Luxembourg was more than member states were prepared to countenance. “But if management companies are able to passport their activities why cannot administrators?”
He also pointed to the fact that there remains the absence of a single supervisory body to ensure a level playing field was achieved. “There is too much latitude for local regulatory interpretation of the directive.” Edge expressed concerns that we could see the development of regulatory arbitrage in Europe as some regulators may be tempted to use a liberal approach to seduce fund promoters from domiciles adopting a more prescriptive approach. He saw opportunities for service providers in developing the concept of ‘management companies for rent’, but was concerned this could lead custodians into uncharted waters. “Would the directive lead to custodians entering the investment manager ‘oversight’ business, thorugh the provision of management companies?” If custody groups did facilitate cross-border companies whose prime activity was asset management, what responsibilities would the group end up with for the delegated manager – periodic oversight, or a full hands-on qualitative involvement in investment decisions?”
He also pointed to the limit of 20% of exposure of UCITS fund activities to any one group, asking is this was a sensible extension of the diversification concept or a potential restriction on universal bank providers such as his group. A custodian bank could be part of a bank ‘group’ involved in a range of activities such as securities lending, foreign exchange, cash management, OTC derivative counter-party, which means UCITS it services could inadvertently be in breach of the 20% exposure limit to one group,
Other aspects that he pointed to were that custodians would be involved in a lot of development work for supporting new fund structures without being sure of what demand would be forthcoming from promoters. In particular, he pointed to the “company administration burden during the transition phase from ‘old’ to ‘new’ UCITS, for which there would be little financial reward. And we are expected to support this.”
More worryingly, he reckoned that if fund of fund volumes increase, the absence of a pan-European clearing and settlement network, such as the NSCC in the US, would place serious strains on existing market infrastructures.
Edge pointed out that there are a number of positive aspects to UCITS III, which would benefit the marketplace. In particular, he pointed to the fund of funds liberalisation, which he says is long overdue.
His overall assessment of whether UCITS III would be embraced was that if the directive was well crafted “fund companies would be consolidating domicile, setting up new products and passporting their management companies. They’re not, so something’s wrong!” He concluded that “perhaps it is a reflection of the myriad of regulatory changes affecting fund management companies right now – EU Savings Directive, Basle II, for example – causing them to give priority to the ‘mandatory’ rather than ‘discretionary’ changes, at a time when margins are being squeezed and available investment monies for taking advantage of all that is good with UCITS III are somewhat limited”.